Crude Swoon Prompts Second Thoughts on Reflation Ahead of Fed

There’s a rebellion against reflation brewing in financial markets, with many Trump trades having a, um, crude awakening this week.

Global stocks have stalled, with the MSCI Emerging Market Index, a benchmark gauge for developing-country equities, down about 3 percent from the more than one-year high reached last month. U.S. stocks are little changed this week. And they’re not alone. Global markets are a sea of red, fueled by carnage in commodities.

Crude Collapse

Today’s proximate cause of the risk-off sentiment in markets: the collapse in crude-oil prices. While there’s uncertainty surrounding how long any deal between OPEC and non-OPEC nations to limit production will hold up, three things are for sure: U.S. shale has come back with a vengeance, inventories stateside are swelling, and speculative positioning wasn’t quite ready for a pullback.

Break-Evens Break Down

Longer-term measures of market-based inflation compensation, derived from the spread between inflation-protected and plain vanilla Treasury yields, had been signaling that reflation was on pause for more over a month. The rally in shorter-term break-evens, which are more sensitive to fluctuations in oil prices, lasted longer — but they too plummeted on Tuesday in tandem with crude.

Limited Breadth in Reflation

One reason why the drop in oil prices presents a threat to the reflation narrative: energy prices have been the principal driver of rising headline inflation this year. Core price pressures in a bevy of developed countries — Switzerland, Japan, Australia — are undershooting inflation targets, while the U.S. and U.K. appear to be on firming footing, according to Nordea Markets. “The recent drop in oil prices have the potential to seriously damage the reflation theme which has had markets in its grip over the past few months,” Martin Enlund, chief currency strategist at the Nordic bank, said in a client note.

Across the Commodity Complex

It’s not just crude that’s swooning.

Commodities soft and hard continue to grapple with supply gluts. For copper, which is said to serve as a pulse for the global economy, a seasonal slowdown in demand and potential for moderation in Chinese activity “caps the upside for now,” say commodities analysts at Bank of America Merrill Lynch.

Look Who’s [Green]Back

A potential additional source of pressure on commodities comes from the currency markets. Dollar bulls have found some luck since February with the dollar spot index gaining about 1 percent, thanks to the tailwinds unleashed from expectations of a Federal Reserve rate hike this month. That has helped stem a reversal in the dollar’s momentum — as it tracked the waning fortunes of Treasury bears — and it remains 1.3 percent weaker than its post-election peak.

Doubts Emerging

The MSCI Emerging Market Index has dropped 1.4 percent since the end of last month, though it remains 2.9 percent higher since the November election. The modest pullback in risk appetite thus far — in tandem with rising expectations of U.S. monetary tightening — stands in stark contrast to the “taper tantrum” that roiled developing country assets in 2013 when then-Fed Chairman Ben Bernanke signaled a reduction in monetary stimulus. That underscores optimism over emerging-market growth prospects this year fed, in part, by reflation in developed markets, say analysts.

Banks Take A Breather

Banking stocks may have fun a bit too far, too fast. The KBW Bank Index has tumbled this month despite a widening spread between 10-year and two-year Treasury yields as the Fed telegraphed a move in March.

Arrested Infrastructure Development

A basket of infrastructure stocks compiled by Bespoke Investment Group — composed of AECOM, Chicago Bridge & Iron Co., Fluor Corp., Jacobs Engineering Group Inc., Martin Marietta Materials Inc., Vulcan Materials Co. and U.S. Steel Corp. — has erased all of its post-election outperformance of the S&P 500 Index amid reports that any stimulus on this front will have to wait until 2018.